Futures and Forwards

Futures and Forwards contracts are an example of equity derivatives deriving their value from the performance of underlying assets. These underlying assets are stocks, index, currency, commodities or interest rates. The two most common uses of Future and Forward contracts are Hedging and Speculation. Having said this, hedging involves offsetting or safeguarding your risk and the hedging position. It is the opposite of a position that one already has in the spot market. On the other hand, speculation involves speculators having enough knowledge about the market. They can predict the market movements to the extent that if they believe the price of a security to hike, they will take a long position and make gains from their forecast and vice-versa.

Futures and forwards contracts allow the investor to buy or sell an asset at a specified time and price. Though they look alike but have a narrow difference which as follows:

Forwards

A forward contract is a private agreement between the buyer and the seller for exchanging an asset for cash at a predetermined future date at a quoted price on the day of the agreement made. Trading of forward contract takes on over the counter exchange and the transfer of ownership occurs on the spot. However, the delivery of the asset takes place only at the specified date. Furthermore, forwards, a customized contract has the conditions like delivery date and price as tailor-made (pre-decided) for meeting the counterparties needs.

Example: Suppose on December 21, 2016, a refiner enters into an agreement with a crude oil supplier to buy 1 million barrels in 3 months’ time at the rate of USD 60/barrel. What is the cash flow consequence on the delivery date for the refiner and the supplier if the spot rate/future price of crude oil is USD 75?

Answer: If the spot rate is USD 75 a barrel, then refiner has the obligation to buy from the supplier 1 million barrels at USD 60 a barrel. Indeed, the refiner will pay the supplier USD 60 million and in exchange will get 1 million barrels of crude oil. Here the refiner benefits, if he buys the same 1 million barrels in the spot market, he might have to pay USD 75 million, therefore his gain is USD 15 million.

Problem of Forward Contracts

The forward contracts lack centralization of trading. They are considerably illiquid in nature and involves counterparty risk. The counterparty risk is one of the major problems of forward contracts and the risks arise when one of the two parties involved in the transaction goes bankrupt. For instance, failure on the tin forward market at the London Metal Exchange.

Futures

Future contracts are standardized forward contracts, which are exchange-traded following the rules and regulation of the exchange. Future contracts are traded on the secondary market and they enable trading of the whole contract and not fractional contracts. A futures contract is an agreement between buyer and seller to trade a commodity or any financial instrument at a future date for a price agreed at the time the contract is drawn up. The future contract exchange acts as a clearinghouse, ensuring the elimination of default risk. To protect from the default risk, the clearinghouse requires the participants to keep their margin money, ranging from 5% to 10% of the face value of the contract.

Example: If an investor purchased a single future contract of June from ABC Ltd. Then he has to buy it at a price prevailing in the market. Let’s say these futures are trading at $80 per share. This implies, the investor agreed to buy/sell at a fixed price of $80 per share on the last Thursday in June. However, it is not necessary that the price in the spot market must be $80 on the expiry. It could be $77 or $82 or anything else depending on the prevailing market conditions. This difference leads to gain or loss.

Uses of Forward and Futures

Hedging

As mentioned earlier, Hedging means to safeguard the risk. To explain the concept of hedging let’s take an example: Suppose wheat farmer enters into a forward/future contract selling his harvest at a known price in order to eliminate the default price risk. On the contrary, a bread factory may want to buy wheat forward/future in order to assist production planning without the risk of price fluctuation.

Speculation

Speculator forecasting the increase in a price might go long on the forward/future market instead of the cash market. He would wait for the price rise and then take a reversing transaction. Speculator gets the benefit of leverage by using forwards and future.

Price Discovery

Price discovery is one of the most powerful uses of forwards and futures contracts. It helps market prices to predict the spot price that might prevail in the future. These predictions are quite useful in production decisions.

To summarise, forwards/futures contracts allow investors to buy and sell commodities or financial instrument at a specific time and price. Future contracts are standardized contracts traded on an exchange. Whereas forwards are private bilateral contracts between two parties that agree to buy and sell a commodity or asset at a specified price in the future. In forward contracts, there is always a risk of default. On the contrary, future contracts have a clearinghouse that guarantees the transaction and eliminates the default risk. Forwards contracts are settled at a specified date at the end of the contract. While futures contracts are marked to market daily, determinating day-by-day value until the contract expiry (last Thursday of every month). Hedgers mostly use forwards to eliminate the volatility in the prices of assets, whereas speculators who predict the future price movements, use futures.

About The Author

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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